Monday, February 11, 2013

Income elasticity of demand has various applications. Explain each application with the help of an example.

Income elasticity of demand may be defined as the ratio or proportionate change in the quantity demanded of a commodity to a given proportion change in the income. In short, it indicates the extent to which demand changes with a variation in consumer‘s income. Thefollowing formula helps to measure the income elasticity (Ey).OrWhere· Ey is income elasticity of demand· D is change in demand· D is original demand· Y is change in income· Y is original income

ExampleOriginal demand=400 units Original income= 4000 unitsNew demand =700 units New income= 6000 unitsChange in demand= 700-400= 300 units change in income=6000-4000=2000Hence Ey=300/2000*4000/400=1.5Generally speaking Ey is positive. This is because there is a direct relationship between income and demand, i.e. higher the income; higher would be the demand and vice versa. On the basis of the numerical value of the co-efficient, Ey is classified as greater than one, less than one, equal to one, equal to zero and negative. The concept of ey helps us in classifying commodities in to different categories.

1. When Ey is positive, the commodity is normal (used in day-to-day life)2. When Ey is negative, the commodity is inferior. ( for example jowar, beedi etc)3. When Ey is positive and greater than one, the commodity is luxury.4. When Ey is positive but less than one, the commodity is essential.5. When Ey is zero, the commodity is neutral. E.g. salt, match box etc.

Practical application of income elasticity of demand

1. Helps in determining the rate of growth of the firm.If the growth rate of the economy and income growth of the people is reasonableforecasted, in that case it is possible predict expected increase in the sales of a firm and vice versa.

2. Helps in the demand forecasting of a firm.It can be in estimating future demand provided the rate of increase in income and Ey for the products are known. Thus, it helps in demand forecasting activities of a firm.

3. Helps in production planning and marketing.The knowledge of Ey is essential for production planning, formulating marketingstrategy, deciding advertising expenditures and nature of distribution channel etc in the long run.

4. Helps in ensuring stability in production.Proper estimation of different degrees of income elasticity of demand for different types of product helps in avoiding over-production or under-production of a firm. One should know whether rise or fall in income is permanent or temporary.

5. Helps in estimating construction of houses.The rate of growth in incomes of people also helps in housing programs in a country.Thus it helps a lot in managerial decisions of a firm.